Value Investing 101
Something often said but not understood..
Value Investing. Something often said but not understood. We here behind the scenes at Canadian Value Investors have collectively spent over two decades talking about Value Investing and have put together the following Value Investing 101 Guide – Or the CVI Value Investing Checklist. This is meant as a 101 guide to get you going as well as help those Continuous Learning Machines and the Checklist Makers out there who want to make sure their bases are covered.
To make this easier to read and find things you want to learn about, we have broken it into: The CVI Investing Checklist, where you develop a structured system to invest, introducing the concepts of an Investment Checklist, investment concentration, permanent capital, and learning from mistakes. Following this, we cover the concept of Investment Cloning, which we believe is an unbelievably undervalued approach, particularly for those early in their investing careers. This includes case studies and step-by-step guides.
The CVI Value Investing Checklist
To be successful at our approach to value investing, you need to have the following:
The Characteristics of a Good Investor
Continuous Learning (Including Learning From Your Mistakes and Others)
1) The Characteristics of a Good Investor
We plan on going into much more detail on this section later, but in the meantime we wanted to provide you with the basic foundation that these investing concepts are built on. To be clear, Checklists, Concentration, Cloning, and other concepts don’t work (and are in fact are probably harmful) unless you have the basics down.
Investing well using these concepts takes a lot of time and knowledge. If you don’t find it interesting to learn about companies and how they work (or at a bare minimum learn what professional fund managers do) then this probably isn’t the thing for you. And that’s OK. Find your niche.
Patience and Decisiveness
Value Investing is both easy and hard. It’s about doing almost nothing and being content with that. You’re pounded by endless ideas and thoughts. “I made money on pot stocks.” “Did you buy bitcoin?” “How could you not be investing in the market?”
Mohnish Pabrai founded Pabrai Investment Funds in 1999 and currently manages over $500 million in a very concentrated value-oriented way (i.e. around 10 stocks). In a 2012 talk with students, he explained his process as follows:
Of course he was at least half joking as continuous learning and self-reflection is extremely important as he notes below.
But the key is you have to be OK doing nothing in the sense of frequently buying and selling stocks. Investment activity doesn’t correlate with success.
The concept is exemplified by Charlie Munger’s activity at the Daily Journal (where is the Chairman, another job he has besides being Warren Buffett’s right hand man) as described by Mohnish.
For full background – in Q1 2009 they purchased $15.5 million of stock and had $10.5 million of cash at the quarter ending March 31, 2009, so they had invested approximately 60% of their cash on hand. In Q1 2009 they had purchased another $4.9 million of stock and ended the quarter with $6.3 million of cash. Based on their cost base of $20.4MM ($14.5MM+$4.9MM) they had basically doubled their money by June 30th as their stocks were worth $46.3MM. Fastforward to December 31, 2017, the total market value of marketable securities on hand was $244.9MM on a cost base of $63.4MM for an annualized return of about 20% per year. Not bad for inactive traders.
Of course, it's patience and gumption that get you there.
Willing to be Lonely
The Power to Take Pain
Note: Mohawk Industries bottomed out at around $20 in 2009 and subsequently increased to $41 by 2010 $150 in 2014 and over $200 in 2016.
The Power of Humility
Understanding Your Circle of Competence
Have Someone to Talk To
2) A Checklist
Checklists are very powerful and there’s a reason why pilots use them – we’re all fallable and forgetful. An example of a checklist of mental biases can be seen on our Behavioural Finance page. But the concept is the same for investments, in that it forces you to examine blind spots, which can be particularly big when you are excited about an investment idea.
These lists need to be built over time based on your experience. As noted by Charlie Munger:
Checklists are particularly useful for learning from mistakes, or working backwards to find out what went wrong and how to catch that type of mistake earlier next time. See our Learning from Mistakes section below for more detail and examples.
We also encourage you to read The Checklist Manifesto, which is its own 101 guide on this process and has fun stories like how airplane pilots use checklists to keep you from crashing on your next trip to Maui (great gift for fearful flyers!).
3) Concentrated Investing
The best book we have found about concentrated investing is the creatively named book Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors.
The book covers several investors (like Warren and Charlie as well as Lou Simpson and John Maynard Keynes among others) and also the statistics behind concentration (we encourage you to read it!). Intuitively, the fewer stocks you own, the more your portfolio can deviate from the benchmark’s performance. But how different could it be? What’s the difference between 10 and 30 and 250?
The authors conducted a Monte Carlo simulation where they randomly built portfolios from the S&P 500 from 1999 to 2014. In each year in the sample they randomly chose a portfolio of stocks, with 1,000 sample portfolios each year for a total of 120,000 portfolios over the 15 year period.
How did they do? 35.2% of the 10 stock portfolios outperformed the benchmark by 1% or more and 2.6% outperformed by 5% or more. At 30, it goes down to 23.4% and zero. Of course, concentration also increases your chances of underperforming the market.
Chance of Portfolio Outperforming S&P 500 Equal Weight (1999 to 2014)
Concentrated Long-term Investing
The most concise explanation we have found on why you should focus on concentrated long-term investments is from Josh Tarasoff, who is General Partner of Greenlea Lane Capital Partners LP.
The system you build for yourself is important. If you convinced Warren Buffett to quit his Berkshire Empire and move into managing an “active mutual fund” that has a policy of having 200+ stocks at all times, has to cover all industry segments “appropriately”, and no one stock can be more than 1% of the fund, we are willing to coffee bet that his performance would be at best equal to whatever silly benchmark the fund has chosen.. and more than likely fall well short leading the fund to be rolled into another one or five of other terrible funds to preserve the fund company’s “active management leadership benchmark #1 spot”. He is an amazing investor but he also built a system that lets him succeed (i.e. where he can concentrate his investments and make infrequent patient decisions).
Concentration Case Study – Mohnish Pabrai’s Holdings (Pabrai Investment Funds)
How do people that actually manage a lot of money concentrate and copy? We put together this case study on Mohnish Pabrai. This is because: 1) He grew assets under management from $1 million to over $400 million in less than a decade, 1) He has been concentrated from day 1, and finally 3) He is a vocal proponent of cloning.
How does he handle his holdings?
Mohnish exemplifies how to practice concentrated investing. Over the course of the history of the funds he has never had more than 20 positions. He also has a demonstrated ability to concentrate when he has ideas with high conviction (here we are separating “conviction” from “being right”).
Idea Shelf Life and Conviction
While he has had a number of small positions, if you look at his hold length it correlates quite strongly with his conviction (implied by the maximum portfolio weighting, i.e. the maximum percentage that an investment was of the entire fund on a percentage basis). For example, Berkshire was his longest hold and accounted for 15.3% of the portfolio vs the average stock weighting of 12% over the history of his fund. American Zinc Recycling LLc is almost just as long at 29 quarters and represented 31.9% of the portfolio at its peak, 62.5% above the portfolio average maximum weighting. The majority of the top 15 longest holds over the history of the fund are or were significantly overweight compared to the average maximum, while all of the bottom 15 holds except for one are significantly underweight.
When to Put Your Chips Down - Select Holdings Over Time
The table below shows his holdings at the first year of reporting, the year with the most holdings, the year with the least, and his current portfolio as of the December 2017 13F.
Pitfalls of Concentration – Case Study: Pershing Square Buying Valeant
In 2015 Bill Ackman bought roughly $4 billion of Valeant Pharmaceuticals, representing approximately 25% of the portfolio at the time. Things were going well over the summer and Ackman was very vocal about his praise for Valeant. But unfortunately the stock later plunged due to U.S. regulators’ probe of Valeant’s pricing policies and problems at its specialty pharmacy unit, Philidor, among other things. He then spent the next two years trying to fix the company but ultimately gave up at the beginning of 2017.
This ultimately resulted in realizing a loss of over $3 billion dollars. While this was a disastrous individual investment, it did not crater the firm.
The key is to recognize that 1) losses and mistakes will happen and 2) when they do, make sure no one mistake can destroy your portfolio.
4) Permanent Capital
We hate leverage. We never invest borrowed money. You’re just not rational when you’re investing money you don’t have. We also hate it in companies we invest in.
– Paul Lountzis, President, Lountzis Asset Management LLC
We are focused here on the individual investor and so by Permanent Capital we basically mean don’t borrow – Permanent Capital has a very different meaning for companies and investment funds.
Berkshire Hathaway has provided a compounded annual gain from 1965 to 2017 of 20.9%, an amazing return and by all standards a great company to have invested in. Yet if you had heavily margined your account by borrowing from your broker or someone else silly enough to lend to you and put it all 100% into Berkshire at some point, particularly in 1975, you would have sunk your portfolio like the titanic. You have to manage prudently – no one wants to go back to Go and start this life game of Monopoly from scratch. In a practical sense this means make sure that no one decision can lead to critical failure.
Note: You can find all of the easy to read letters here - http://www.berkshirehathaway.com/letters/letters.html
5) Learning from Mistakes
Terribly smart people make totally bonkers mistakes.
– Charlie Munger, USC Business School 1994.
Document, document, document. There are so many mental biases we all have that one of the best things you can ever do for yourself is to document your decisions, and decisions of others, and why it did or did not work. In fact, we strongly recommend reading our Behavioral Finance section and familiarizing yourself with common fallacies we are all vulnerable to. http://www.canadianvalueinvestors.com/behavioural-finance/
What this means in practice is doing a post mortem on investment decisions. Clearly document why you are buying something before you buy it and make sure you frequently check this rationale list while holding (to ensure the world has not changed your thesis) and document the outcome after a sale. Ideally you then turn these learnings into a formal Checklist.
A simple example of this is Pavel Begun’s reflection on why they (3G, not the Brazilian firm) bought and sold AlarmForce. - http://www.canadianvalueinvestors.com/home/2018/3/4/alarmforce-tsxaf-why-did-3g-buy-and-sell-alarmforce-and-why-didnt-we-buy-it
Almost all great investors we have read about have talked specifically about learning from your mistakes in a structured sense. The most comprehensive person we have found talking about this Mohnish Pabrai. He does post mortems on his mistakes and others and has turned them into a Checklist process.
Next Steps: Suggested Resources
In our opinion the best overall book on investing and business is Essays of Warren Buffett which essentially compiles Buffett's views on a range of subjects, such as accounting, finance concepts, corporate governance, business competitive advantages, etc. These views are primarily compiled from his annual shareholder letters (found here) and his other writings, and is written in a very accessible way.
A slightly more complicated/less accessible is You Can Be a Stock Market Genius which has a horrible name but good concepts.
Listening to investors – We strongly recommend going these Ivey videos, which can be found here: https://www.ivey.uwo.ca/bengrahaminvesting/resources/videos/
For Checklists, read the Checklist Manifesto. Concentration fan? Check out Concentrated investing linked below.
And of course. The classic by Benjamin Graham.